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Large retirement account balances can cause Social Security tax problems

The Tax Torpedo

When you reach age 70 ½, the trigger requiring distributions from qualified retirement accounts is pulled. This annual Required Minimum Distribution (RMD) applies to Traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k), 403(b) and other defined contribution plans. Amounts not distributed on a timely basis could be subject to a 50% penalty. Thankfully, the RMD rules do not apply to Roth IRAs.

The RMD rules are established to ensure the deferred tax benefit for certain retirement accounts does not go indefinitely into the future. In other words, the IRS now wants their cut of your tax-deferred savings accounts. The amount you must take out each year is based upon your age, your spouse’s age and your filing status.

The Tax Torpedo

The Tax Torpedo refers to the surprising event of having your Social Security Income taxed. Depending on your income and filing status, up to 85% of your Social Security Benefit could be subject to income tax.

RMD causes Tax Torpedo

If you continue to wait to start taking money out of your retirement accounts, the balance in your accounts may be very high when you reach age 70 ½. These higher balances mean a higher annual withdrawal amount. If your required retirement plan distribution is large enough it may put you into a higher marginal tax bracket as well as trigger taxes on your Social Security.

Some Tips

Plan withdrawals. Once you hit age 59 ½ you may withdraw money from qualified tax-deferred retirement accounts without experiencing an early withdrawal penalty. To reduce the tax risk on your Social Security, manage annual disbursements from your retirement account(s) to be more tax efficient when you reach age 70½.

Starting Social Security. You may begin full Social Security Benefits after you reach your minimum retirement age. However, your benefit amount can increase if you delay your start date up until age 70. Consider this as part of your plan to manage a potential Tax Torpedo.

See an advisor. There are many moving parts in planning for retirement. These include Social Security Benefits, pension plans, savings, and retirement accounts. Ask for help to create the proper plan for you and your family. One element of the plan should include being tax efficient.